In this Q&A article, we’ll cover two questions – no, they are not related. Just that they are interesting questions and which you may relate to. Like the first question, which is on where to invest for your emergency fund, given that liquid fund returns (the usual go-to) are dwindling.
On emergency funds
Q We’ve received several questions from you on emergency funds in general. But of late, questions on this topic now ask other fund options that can give high returns as liquid fund returns are low. Some of you have also asked us which other categories you can use for SWPs as returns are low.
A. The need to be alternatives appears to stem from sliding returns of liquid funds, coming off high returns. 3-month returns for liquid funds have slipped below 1% now. 1-year returns have dropped down to 5%. For 2018, 1-year returns averaged 6.98% while it stood at 7.3% on an average in 2019.
With interest rates trending south, obviously, liquid funds returns are going to reflect the change more quickly than other fund categories. Banks themselves have significantly slashed fixed deposit rates. The question is – should you maintain your emergency fund portfolio in other avenues, in order to eke out better returns?
An emergency fund portfolio needs to have the following characteristics:
- It needs to be very liquid.
- It needs to be safe from losses and fluctuations in returns as you need to tap into this amount when your normal financial circumstances go awry. You cannot risk that the value of this corpus depletes because returns are volatile.
- It needs to be in a short term fund. This is derived from the point above. Long-term investments typically involve volatility and may underperform in short-term periods. Since you do not know when you need to tap into your emergency money, you cannot take on risks of underperformance.
This means you need debt. Specifically, very short-term debt with no risks or volatility. This limits the range of options available. The table below shows how the different debt fund categories stack up on deviation and volatility in returns on a 1-year basis and loss probabilities in 1-month periods.
The above table is not to suggest that you will get at least 5.15% in liquid funds. It could go below that as well. For example, if you try and annualise the current low rate of 0.95% in 3 months (absolute), it comes to a measly 3.8% per annum. That cannot be ruled out if current low rate scenario continues.
What we are trying to showcase through this table is the ability of liquid funds to avoid losses and generate more predictable returns than all other categories.
Liquid funds are also more predictable of the lot, as they necessarily need to invest in papers with a 91-day maturity. Their portfolio is predictable in that they will simply hold short-term instruments. These funds take no credit risk. This combination of high safety, low volatility, and stable strategy is hard to find in other debt fund categories. More, SEBI rules in this category have tightened to reduce risks still further. Do note, here, that falling returns in liquid funds because of a low-rate scenario does not translate into a fund underperforming.
However, you can turn to other fund categories in addition to liquid funds in your emergency fund portfolio. This will help your portfolio generate better returns without compromising much on the risk or volatility front.
These are ultra short term debt funds, low duration, money market, and floating rate funds. These are also funds with low average maturities. They primarily invest in commercial paper, bank certificate of deposits, and treasury bills. The low maturity and the nature of instruments does limit volatility.
Go for funds with low credit risk, and review the funds once a while to check that they are still suitable.
But before jumping on to these funds, note the following:
- Low maturity does not mean low risk. Credit risk is the one you know very well. Many funds in these categories do invest in papers with low rating. While CPs and CD holdings are usually of the top credit grade, funds in the ultra short and low duration space often go for short-term bonds (or bonds with short residual maturities) of companies which have low credit rating.
- Strategy can change. A fund that was previously high-quality only may change portfolios to take on riskier papers to prop up returns in a falling rate cycle. A fund that currently holds treasury bills and CDs may move to short-term bonds later if more attractive rates are to be found. This can induce volatility in near-term returns.
Therefore,one, go for funds with no credit risk. Two, in your annual portfolio review, check that these funds remain low-risk. If the fund’s nature has changed, switch into a suitable fund. Three, do not allow such funds to form the entirety of your emergency fund portfolio.
You can pick from our recommended list of funds – Prime Funds in the 3 months – 1.5 years’ time bucket for such funds. Make some allocations to them along with liquid funds and fixed deposits. You can use our readymade emergency fund portfolio or take cues from it.
We have a more detailed explanation of how much your emergency fund should be and what should make up an emergency portfolio here. Remember, in an emergency fund, high returns is not what takes importance.
The same holds true, to a large extent, about funds suitable for SWPs. Here, you do need to look for better returns, but safety still takes precedence. For immediate SWP needs, liquid funds continue to remain the best option despite low returns, followed by the very short-term funds as explained above. Funds from other categories need a longer timeframe before you can start SWPs; you can find a detailed explanation on where to invest for SWPs here.
On the hold calls in review
Q The buy/sell/hold calls we give on funds in our MF Review tool throw up an array of questions. One among those is why you should ‘hold’a fund (with a hold call) at all and why you can’t simply sell it outright and reinvest in a ‘buy’ fund.
A. In succinct terms – this will lead to unnecessary portfolio churn and tax outgo, quite apart from resulting in chasing returns. To explain, a fund moves to a hold because there is some slip in performance. There are a range of reasons for this, including but not limited to:
- Change in fund strategy, where the fund manager is overhauling the portfolio and refining the stock selection process.
- The fund has seen a few calls go wrong which is pulling down the portfolio returns.
- The strategy is such that it goes through periods of underperformance only to bounce back later. This is true of value-based and momentum-based strategies.
All this requires a wait-and-watch approach to see if fund performance revives or continues to flounder.
A fund that is otherwise good, that is now underperforming, can well pick up later down the line.
Take the first point. UTI Equity was an underperformer, and then underwent a strategy change in 2016. It remained a mid-range performer until 2018, when it picked up and is now among the better funds in the multi-cap space.
Consider point 2 above. When funds get a few calls wrong and it hurts their return, it will take time for them to reset their portfolios and recoup the performance slide. As long as the fund is trying to turn around, there is no reason to exit. A good example here is Axis Bluechip. This fund was initially among the best large-cap funds, but slipped in 2016 and 2017. As you now know, it is ranking at the top in the large-cap category steadily.
What we’re trying to say is this: a fund that is going through a phase of poor returns does not automatically make it a sell. It requires understanding of the reason for the performance and looking at changing trends in returns. A fund that is otherwise good, that is now underperforming, can well pick up later down the line.
Therefore, there is no real reason for you to sell such a fund: one, it can continue to deliver for your portfolio. Two, improving performance means that you can restart investments in the fund which helps keep your portfolio compact. Three, it will prevent you from selling when returns are not optimal and pay up capital gains tax. Four, it will help you avoid chasing after funds with high returns, as you are likely to do by exiting as soon as performance dips.
When we give hold calls on funds, it is because we are seeing a slip in performance due to various factors. Two, it could be because a poor performing fund is beginning to improve – say, for example, it is moving from a 1.5 star to a 2.5 star and recent performance is showing an uptick. Both mean that waiting it out could see improved returns.